Contributed by Will Hueske
The nation’s higher education system continues to struggle to regain its financial footing following the Great Recession, and as a recent Moody’s survey of the sector suggests, the factors contributing to those struggles—depressed tuition revenues, reduced federal and state funding, market volatility affecting endowments—are unlikely to abate in the short-term. Skyrocketing tuition rates at both public and private schools over the past decade have had the dual effects of reducing enrollment and ballooning the average educational debt that students face upon leaving—either with or without a degree—and the default rates on such debt continue to rise. In the face of these challenges, some schools have had no alternative but to significantly cut back course offerings, put themselves up for auction, or even seek bankruptcy protection.
In the recent case of In re Lon Morris College, however, the Bankruptcy Court for the Eastern District of Texas held that filing for bankruptcy can automatically strip a school of a critical financial asset—eligibility to participate in the federal student loan and assistance programs. As reported by the Dow Jones Daily Bankruptcy Review here, the school’s unexpected ineligibility to continue receiving funds under Title IV of the Higher Education Act led to its sudden liquidation and piecemeal auction. Lon Morris serves as a warning that struggling and insolvent colleges and universities must carefully consider their strategy in pursuing a chapter 11 filing, as the filing itself may permanently weaken the school’s ability to operate and as a result may prevent the “fresh start” that it seeks.
The Title IV Program
Title IV of the Higher Education Act of 1965, 20 U.S.C. § 1070, et seq. authorizes a variety of financial assistance programs for institutions of higher learning and their students. These programs include Pell Grants, Stafford Loans, PLUS Loans, and others. Without the financial aid provided by the Department of Education through Title IV, many students would be unable to afford postsecondary education, and many institutions of higher education—whether they are public, private non-profit, or private for-profit—would be unable to finance their operations.
In the late 1980’s, however, widespread reports began to surface of institutions of higher learning (primarily private for-profit or “proprietary” institutions) exploiting their Title IV eligibility by aggressively recruiting and enrolling students into overhyped and underfunded programs. A Senate investigation discovered schools heavily front-loading the costs of tuition, collecting Title IV assistance directly from the Department of Education, using the tuition to pay school executives exorbitant salaries, and then, in the worst of cases, closing and/or filing for bankruptcy protection when faced with the impossible task of refunding Title IV funds to the large number of students who dropped out. In 1991, the Senate issued a report on its findings of waste, fraud, and abuse in the Title IV program, noting that:
[U]nscrupulous, inept, and dishonest elements . . . have flourished throughout the 1980s . . . by exploiting both the ready availability of billions of dollars of guaranteed student loans and the weak and inattentive system responsible for them, leaving hundreds of thousands of students with little or no training, no jobs, and significant debts that they cannot possibly repay. While those responsible have reaped huge profits, the American taxpayer has been left to pick up the tab for the billions of dollars in attendant losses.
S. Rep. No. 58, S. Rep. 102-58 (1991). Shortly thereafter, Congress amended the Higher Education Act to, among other things, strip any institution of higher learning of its Title IV eligibility if such institution filed for bankruptcy protection. 20 U.S.C. § 1002(a)(4)(A). This particular amendment was intended to eliminate the use of the bankruptcy laws, namely the automatic stay, in order to escape action by the Department of Education against an unscrupulous institution, as noted by the Senate report:
By securing the protection of the [bankruptcy] court, which has an interest in seeing that the schools survive through reorganization, even a school that cannot make loan refund payments to former students may continue to admit new students who in turn incur student loan obligations [even though that] school may well close or otherwise cut back its educational program.
S. Rep. No. 58, S. Rep. 102-58 (1991). Yet, this form of targeting would seem to run afoul of section 525(a) of the Bankruptcy Code, which prohibits governmental units from denying, revoking, suspending, or refusing to renew a license, permit, charter, franchise, or other similar grant to an entity solely because of such entity’s status as a debtor under the Bankruptcy Act.
In re Betty Owen Schools, Inc.
Until Lon Morris, the only court opinion on the issue was given in the case of In re Betty Owen Schools, Inc., 195 B.R. 23 (Bankr. S.D.N.Y. 1996). In Betty Owen, the debtor was a not-for-profit vocational school located in New York City. Upon filing for chapter 11 bankruptcy protection, the debtor sold substantially all of its assets to a new owner in a 363 sale. Under the statute and regulations of the Higher Education Act, specifically 20 U.S.C. § 1099(c)(i)(1) and 34 C.F.R. § 600.31, when an institution of higher learning is acquired by a new owner, the institution loses its Title IV eligibility, but the new owner may immediately reapply for eligibility. This allows the new owner to avoid the standard two-year waiting period imposed on new institutions and minimizes disruption in operation of the school. In Betty Owen, the 363 purchaser planned to take advantage of this process to immediately seek Title IV eligibility upon the closing of the 363 sale.
However, after the sale, the Department of Education refused to allow the purchaser to use the expedited reapplication process, reasoning that, because the school had lost its Title IV eligibility upon the bankruptcy and prior to the sale, the transfer of ownership procedures did not apply and the new owner was subject to the standard two-year waiting period before it could seek Title IV status. Both the debtor school and the purchaser objected to the Department of Education’s actions under § 525(a).
The court upheld the § 1002(a)(4) amendments stripping the debtor of Title IV eligibility, stating that “courts are bound by Congressional judgments that general bankruptcy policy give way to more specific policy considerations,” and in the case of the amendments to § 1002(a)(4), Congress’s specific intent to prevent institutions of higher education from seeking refuge in bankruptcy to avoid action by the Department of Education must override the general “fresh start” policy of § 525(a). The court also refused to disturb the decision of the Department of Education disallowing the purchaser to immediately reapply for Title IV eligibility, noting that the Department’s decision was “a business risk that [the purchaser] undertook when it purchased the Debtor’s assets.” The Betty Owen case was not revisited by the bankruptcy courts until Lon Morris.
Lon Morris College
Lon Morris College, a private junior college located southeast of Dallas in Jacksonville, Texas, had served its local community since its founding in 1854. In 2008, however, the college began experiencing substantial negative cash flows from reduced enrollment and increased tuition receivables. The college took steps to increase enrollment, hoping to curtail its tuition losses, but the new, larger classes of students, in turn, necessitated the construction of new dormitory facilities, which were financed by incurring even more debt. In July 2012, the college ran out of cash, its president resigned, and a chief restructuring officer guided it into chapter 11 protection with the goal of continuing to operate while restructuring the college’s debts and seeking a financial partner to recapitalize or acquire the school as a going concern.
In August 2012, the Department of Education notified Lon Morris that its eligibility for Title IV programs had been revoked due to the bankruptcy filing. Lon Morris responded with a motion seeking an injunction of the Department’s action under section 525(a) and seeking monetary damages, noting that “[b]ecause of the DOE’s actions, Lon Morris’ ability to sell itself as a going concern has been impaired and Lon Morris has lost value.”
On August 20, 2012, Bankruptcy Judge Parker in the Eastern District of Texas issued a bench decision on whether the Department of Education may properly revoke a bankrupt college or university’s eligibility under Title IV simply by virtue of the institution’s bankruptcy filing. In his opinion, Judge Parker followed the reasoning of the Betty Owen court, holding that:
[I]t is a clearly expressed subsequent Congressional choice that the public policy supporting access to bankruptcy relief must necessarily yield in this limited instance to the public policy protecting students and their investment in their education, as well as protecting the vast sums of money that American taxpayers invest into higher education for its citizens through the availability of federally backed student loans.
Judge Parker further noted that the situation before him was “clearly distinguished from a fly-by-night, for profit, limited time venture, maybe by questionable entrepreneurs seeking to fleece the student loan system;” i.e., the type of institution that Congress was targeting with the 1992 amendments. Nevertheless, the Department of Education’s action was upheld.
Upon the order affirming the Department of Education’s revocation of Lon Morris’ Title IV status, the college was no longer able to market itself as a going concern and concluded that the only available option was an orderly liquidation. As noted in its disclosure statement, filed in October 2012:
The result of the Bankruptcy Court’s decision was that the Debtor could not enroll a fall class. Students were dependent upon federal aid and would be unable to pay for their education; the Debtor would have no receipts and would be unable to pay faculty and operating expenses. The Debtor was forced on an emergency basis to transfer its students to other colleges and suspend the fall semester, while it continued to attempt to sell itself as a going concern, to no avail. After discussions and meetings with secured lenders, the Debtor proposed an auction process with a sale confirmed through a plan of reorganization that permits the Debtor to dispose of its assets.
The college’s plan of liquidation was confirmed on February 12, 2013, and the sale of the college’s property and assets was approved. The real estate formerly occupied by Lon Morris was purchased in part by the Jacksonville Independent School District to make room for a new elementary school.
The consequences for the chapter 11 cases of institutions of higher learning are significant. If an institution of higher learning loses its Title IV eligibility immediately upon filing, it most certainly will not be able to continue as a going concern and may lose substantial value to investors who may have otherwise sought to take control of the assets via a 363 sale. The 1992 amendments to § 1002(a)(4) appear to render a bankrupt institution permanently ineligible for Title IV so long as the debtor maintains ownership of the school, as there are no provisions related to the reinstatement of Title IV eligibility after an institution of higher learning exits bankruptcy. Moreover, while a bankrupt institution may sell its assets in a 363 sale and the school may take on new ownership, the value of those assets as a going concern will be greatly diminished given the Department of Education’s actions in Betty Owen. An institution of higher learning without the benefit of Title IV eligibility has little prospect of continuing to serve its students and community, and as the nation’s higher education system continues to adapt to new economic realities, the Lon Morris case will no doubt inform efforts to restructure debt and keep struggling institutions afloat.